Moneyball without the ball

Posts tagged ‘investment idea’

I owe this idea to @teamonfuego. He brought it up to me a couple weeks ago. Unfortunately, I was on vacation and I was slow to the punch. As it was I ended up picking up the stock at $1.10 on average.

Liqtech has been your typical little energy technology company. They have an interesting technology but have struggled to sell it into established markets that aren’t all that interested in new ideas.

The consequence is that the stock has spent years bouncing around with no real upward momentum, every year losing money and raising capital.

What they sell

Liqtech sells a suite of silicon carbide filter products. They’ve tried to break into oil and gas, into mining, even into pools and spas. But they’ve only had moderate luck. They have a small but fairly steady business selling diesel particulate filters (around $8 million a year of revenue). Beyond that they sell a few filter systems a year but never enough to break-even on a consistent basis.

From what I can gather, their lack of success is not because of the product. The silicon carbide filter is a better product for many industrial waste/purification applications than what is used right now. But that doesn’t always guarantee a win.

The problem has been getting a foot in the door. This article, from way back in 2014 with CEO Sune Mathiesen, describes the problem that the company has had in the past:

My initial, and most important focus point was to turn the Company around from being a supplier of membranes into a supplier of complete water treatment systems. Since LiqTech started commercializing its membranes in 2009, it has proven very difficult to convince system integrators to invest time and money in developing systems around our membrane technology. The reason is simple, most engineers know how to build a system around sand filters, polymer membranes or other well-known technologies, but they don’t know how to handle our silicon carbide products.

Beginning in 2015 Mathiesen made the transition from selling membranes to selling filter systems. They began to research and invest in building a full filter assembly so they could by-pass the system integrators.

Three years has passed and the stock hasn’t exactly lit the world on fire. But they’ve been slowly built out a product line of filter systems for various applications. And now one of those applications appears about to take off.

IMO 2020

IMO 2020 refers to new regulations from the International Marine Organization that come into effect in 2020. These regulations change the pollutant requirements of bunker fuel, reducing the maximum SO2 concentration in marine fuel exhaust from 3.5% to 0.5%.

About 60-70% of the shipping fleet uses a bunker fuel that has >0.5% SO2. The most common bunker fuel has SO2 of about 2.7%. The ships that use this fuel will have to do something about that by 2020.

The ship owners don’t have many choices. They can either switch to a more expensive low sulphur fuel or install scrubbers that clean out the SO2 from the high-sulphur bunker fuel.

The economics around fuel switching versus scrubbers is in favor of the scrubbers. Here’s a quote from Rudy Kassinger, consultant at Veritas Petroleum Services, from this article:

The cost of installing scrubbers is somewhere between $3 million and $6 million depending on the ship (though I have seen estimates that use a high-end number as much as $10 million). The payback on scrubbers can be 1-3 years. Most of the articles I’ve read peg the number at 2 years, which is not too bad.

So how does this impact Liqtech?

Liqtech filters are installed as part of the scrubber assembly.

Scrubbers can operate in open loop, closed loop or hybrid configurations. When a scrubber operates in an open-loop, sea water is used to remove pollutant from the exhaust stream. The sea water is then discharged back into the ocean.

But in harbors and in some regulated waters seawater discharge is not possible. In these areas a closed loop or hybrid system needs to be used where no polluted water is discharged.

The closed loop requires that the effluent water be filtered for re-use. This is where Liqtech filter systems come in. The silicon carbide filter is ideal for the application (in terms of durability, temperature resistance, corrosion and operating performance).

The opportunity for Liqtech is large. Each scrubber installation needs a filter. Ships require on average 1.6 scrubbers (so some need 1, some need 2). The shipping fleet is about 70,000 vessels. Some percentage of those ships will be retrofitted for filters. As well more new builds will include scrubbers going forward.

According to Goldman Sachs less than 500 ships have scrubbers installed today. Goldman estimates that by 2025 we should expect to see over 5,000 ships equipped with scrubbers. Other estimates are even higher. The IMO put out its own estimate (quoted in this WSJ article) forecasting 4,000 ships with scrubbers by the end of 2020. Liqtech said on their second quarter call that:

Analysts believe that by 2025 roughly 14,000 vessels are roughly 20% of the global fleet with have a scrubber.

Whatever the number, its meaningful to Liqtech. Liqtech sells the marine scrubber filters for about $450,000 a unit. At 1 scrubber per ship, the total addressable market is somewhere between $1.8 billion and $6.3 billion.

Liqtech has 72.7 million shares outstanding and no debt. So even after the latest run, its only a $87 million market capitalization company. The addressable market is truly multiples of the capitalization.

The obvious question is what sort of market share can they capture? Things look pretty good so far.

In March they announced a framework agreement with “one of the world‘s largest manufacturers of marine scrubbers” for “an initial term for 2018 and 2019 and provides that more than 95 systems are estimated to be delivered”

In April they announced a second framework agreement for “a minimum of 35 systems are estimated to be delivered during the initial term” of 2018 and 2019.

Also in April they announced a letter of intent with “one of the world’s largest marine scrubber manufacturers”. This was extended in July. On the second quarter call they said the LOI was for 95+ systems.

On the first quarter call Liqtech said they were working with five or six of the largest scrubber manufacturers. They said on the second quarter call that they are expecting to see orders coming from other sources as well:

we believe that we see a lot of the orders in the future come directly from the shipyard operators. It doesn’t necessarily mean that — or it doesn’t mean that we’ll not see orders coming from scrubber manufacturers, it just means that I have told to several sources for orders in the future.

I’d make a guess that the 95 system framework agreement is with Yara, which is a large scrubber manufacturer. Liqtech has previously disclosed they have been working with Yara. A look at this Yara video shows a filter that looks pretty much the same as what Liqtech shows in their own presentation.

I’m not sure who the other 35 systems or the LOI are with. The list of scrubber manufacturers includes: Alfa Laval, Wartsila, Saacke, Yara, Puyier, DuPont, and Feen Marine. Liqtech has said there are 10 major manufacturers in total.

So what kind of impact is this going to have on the bottom line?

I think its going to be significant. Here are a few points to consider.

The company says their break-even is $16-$18 million of revenue, on the sale of about ~20 filters systems for marine scrubbers

On the second quarter call they said incremental systems sold should expect 70-75% gross margins and they have also said they expect 65% contribution margin from incremental sales

The current expense run rate is $1.25 million per quarter

There are $14 million of NOLs in the US and another $6 million in Denmark

I’m assuming they need to sell about 20 systems in 2019 to hit a break-even point at current run-rates. If the two framework agreements come to fruition they will sell 130 systems, heavily weighted to 2019. Let’s say they sell a total of 80, so 60 that are incremental to the break-even number.

I’m throwing in the 21% tax rate even though they shouldn’t be taxed through most if not all of 2019. Un-taxed EPS is over 23c with these assumptions.

Conclusion

One downside is that sales of filters to the existing marine scrubber fleet is not going to last forever. There are limits on ship-yard capacity which will extend the retrofits out to 2025. But probably some time around then (maybe sooner, maybe later depending on how things play out) the installs will taper off.

There will be continued sales from new-builds after 2025. There are 70,000 ships globally. It seems like for most markets (containerships, dry bulkers, tankers) at least 3% of the fleet is added every year. So that’s ~2,000 ships a year. On the first quarter call Liqtech said they expect to see a further uptick on the 30-40% of new-builds that are currently being built equipped with scrubbers. So the opportunity is not insignificant.

Also, by the time the retrofit opportunity is exhausted, and assuming everything plays out positively, Liqtech will have an install base numbering into the 100’s of ships.

I would expect it will be a lot easier to hock their product to big oil producers, power producers, miners, and municipal water suppliers with a resume that includes a major vertical that has accepted their filters in an extreme environment.

But that’s a long way off. For now, its enough to say that the stock is cheap if they can secure the expected number of deals from the existing framework agreements and have those agreements project forward, and it is very cheap if they can capture even more market share from other scrubber manufacturers and shipyards.

A second risk is that they start to see price pressure. They are the only provider of a silicon carbide filter but there is competition by way of centrifugal filters. Liqtech has said before they are the cheaper and better option. But as the higher volumes are borne out you have to expect competition. The margins I’m showing in the table above are admittedly very high, and unlikely to be sustainable in the long run.

A third risk is that IMO 2020 gets delayed. From everything I’ve read I don’t see this happening. But you never know.

The bigger upside is that they capture a larger share of the market. I’m assuming about 80 filters a year. The opportunity size is significantly larger (as much as 14,000 installs according to Liqtech) next 5 years.

The other upside is that I have to think it will be easier to sell into other verticals once they can come to these customers with a portfolio of installs throughout the marine scrubber industry.

Anyways, it seems like a pretty tiny capitalization for such a big opportunity. Worth a portfolio spot in my opinion.

I wish I had finished this write-up a day early. I do not like writing up a stock that just went up 15%. But that’s where we are with RumbleOn. I’ve been working on the research and writing all week and then the stock goes parabolic today. I see no news to speak of. Anyways it is what it is, and like all my ideas I’m in this for the long term (insofar as the thesis holds up). Having said that, buying a stock up 15% the previous day is generally not a great idea.

I got the idea a month or so ago from a search of stocks at their 3-month high. When I’m bored and looking for ideas I will go to the 52-week highs or 3-month highs or some other simple price movement screen that gives a signal of strength and I’ll dig into some of the names.

I’ll look for a name that I haven’t heard of, usually keying on one that is small, and I’ll do a bit of work to see if its worth a closer look.

Anyways that’s how I found RumbleOn.

What was fortunate about the timing was that I had just been looking at Carvana. Carvana operates an online used car business that is similar to what RumbleOn does for motorbikes. When I looked at Carvana I couldn’t believe how expensive it was. When I looked at RumbleOn, I couldn’t believe how cheap it appeared in comparison.

Having dug into it further I’m still of that mind. In fact it seems to me that RumbleOn has a better business model than Carvana. I’ll give that comparison in a bit, but first let me describe what RumbleOn does.

An Online Motorcycle Marketplace

RumbleOn operates an online marketplace for buying and selling used motorcycles. They have a website (rumbleon.com) as well as an iOS and GooglePlay app.

The company makes cash offers for bikes to individuals looking to sell. If accepted, the bike is shipped to one of their regional partners (dealers), inspected and reconditioned and then put up for sale on the site.

Anyone can sell their bike to RumbleOn. Upload the vehicle info, fill out a form, add a few pictures and RumbleOn will make you a no-haggle offer. Its good for 3 days and you either take it or leave it.

It’s meant to be the opposite of going to a dealer or selling the bike yourself. There is no haggle, no pressure tactics, and you won’t deal with tire-kickers or nitpickers.

For a while RumbleOn also bought bikes through auction and had dealer inventory on their site. However they’ve stopped both as their retail acquisition channel has become self sufficient. They do buy bikes via some auto-dealers that take them on trade but don’t have a marketplace and just want to get rid of them.

Early on the goal was to insure that the site had adequate inventory. So the company reached for it from other channels. They are now focused entirely on generating inventory through consumers.

Buying a bike on RumbleOn is geared to be just as simple. Pick a bike from the available selection and put down a $250 deposit. The full price of the bike is paid in cash or financed through an unaffiliated bank or credit union partner shortly after.

Unlike most of the online used car dealers (like Carvana), RumbleOn is agnostic to who they sell the bikes to. Most of the car selling sites are focused on the consumer channel.

RumbleOn does that, but they also sell to dealer and auction channels. At the moment dealers are most of the business (via online and through auction). They made up 91% of sales in the first quarter while consumers made up just 9%.

The company expects to build out the consumer channel as awareness of the brand grows. This is a new business, a little over a year old. Marketing of the app and website should grow the percentage of sales coming from consumers. I expect all the channels will grow but that consumer sales will grow the fastest.

Margins on consumer sales are higher so they are the preferred customer. With a dealer sale RumbleOn has to share the margin.

In the first quarter dealer sales had an average selling price of $8,874 at a 7.8% margin while consumer sales had a $12,207 selling price and 13.7% margin.

Gaining Traction with Consumers

The website and app are only about a year old. Consumer momentum takes time. AppAnnie and Alexa show that both the website and the app are growing in popularity.

AppAnnie Ranking

Alexa Traffic Rank

Bringing retail owners and buyers to the site is all about experience. RumbleOn needs to make the experience, both for buying and selling a bike, as painless as possible.

Buying or selling a bike is not a lot of fun. The alternatives to RumbleOn are selling your bike yourself or selling to a dealer. If you sell yourself then you will inevitably “suffer the tirekickers and hagglers and deal with shaky payments”, in the words of one Harley rider commenting on a forum about the service. Selling to dealer likely means haggling, waiting onconsignment or a lower price than what RumbleOn can offer. Buying a bike offers the same problems in reverse.

What RumbleOn has to do is make the experience so effortless that its worth your while to give up a little margin.

It’s a trade-off to bike enthusiasts. Reading the reviews of RumbleOn and reading through forums where bike riders talk about buying and selling their bikes, its something that potential bike sellers are very aware off.

The most common complaint you hear about RumbleOn is that their offers are too low. But most bike owners also understand what they are getting in return for the margin they lose (which amounts to maybe $1,000). They get guaranteed cash and no hassle. They do not have to live for weeks or months with strangers coming over to their garage, trying to push a lower on price, and dissing their bike on minor issues. They also recognize that the offer price is usually better than what they’d get from a dealer.

Sales Growth

So far the model is working. Bike sales went from 355 in the fourth quarter of last year to 878 in the first quarter. The company said they expected that to double again in the second quarter.

I was a bit worried about how they could double sales when the website/app bike inventory seemed to be stagnating. At the end of the first quarter inventory was a little above 1,000 units, whereas now it is slightly below that number.

But it turns out this isn’t the case. Inventory has been rising. The appearance of stagnant inventory is because of the removal of dealer listings.

Adding Bikes

If you go back to the first quarter call management was asked about the disappearance of the dealer listings:

And then just as a follow up, it looks like you’ve taken the dealer listings off the site, is that a temporary thing or is that a permanent change?

Marshall Chesrown

Yes, I wondered if someone is going to say that. We have a plan – we’re getting ready to launch as we said some really, really interesting enhancements, I will be interested to get everybody’s feedback on them with regards to the website and we do see a huge opportunity to be a significant listener of vehicle both for consumers and dealers but we want to do it in a different format and I won’t get into all the details of it but I would tell you that before the quarter you will see what that plan is as it’s rolled out.

Excluding dealer listings, inventory has grown from ~125 in November of last year, to ~300 in March and now to a little over 1,000 today.

My take is that inventory procurement is the gating factor. The company has said that themselves. On the fourth quarter call CFO Steve Berrard had this to say:

This is really a buying product challenge. It’s not selling it. We proved we can sell it by the fact you know, when is the last time you heard a vehicle retailer have days-turns in the 20s, because the market is there to sell it. It’s buying of it, that’s the bigger challenge for us.

A key metric to watch will be how well they continue to acquire inventory. The ramp over the last 3 months as well as the confidence they showed by removing dealer listings are positive data points.

Acquiring inventory is all about making lots of offers and getting the owners to accept them. To expand inventories RumbleOn needs to:

ramp offers

improve acceptance rate

The ramp of offers is all about using technology to streamline the process:

We already which is very early in the cycle earlier than we anticipated we already do not have data people but data is being produced by our system and the data that we have we simply have a supervised whether it is released in those vouchers if you will, those cash offers. We have gone from being able to do about 20 an hour with the new technology enhancements, a single supervisor can do about an 100 an hour

Cash offers were 3,900 in the fourth quarter. That improved over 200% in the first quarter to 12,000. On the last call they said they were on pace to double cash offers in the second quarter.

Acceptance rates on those offers have been trending in the right direction as well. Acceptance rates were 12% in the fourth quarter rising to 14.9% in the fourth quarter. Chesrown thinks they can get this as high as 20% over time.

So all good signs. Even so I feel like obtaining the right inventory at the right price is going to remain the big challenge for the business.

Reviews

Case and point: if you look for negative reviews of the company, what you find will almost inevitably be a bike owner complaining that the offer RumbleOn made for their bike is too low.

The business is based on the premise that you are saving enough in terms of time, hassle and getting a guaranteed cash payment to make you willing to give up the $1,000 that you might get if you sold the bike yourself. And this is an equal or better price, all with less hassle, then you’d get if you went to your local dealer to sell.

Other than the complaints about the offer prices the reviews are almost all positive. Customers get paid for their bikes on time, they receive their bikes quickly and they are consistent with what was ordered. The app is easy to use, it’s a simple process to get an offer on your bike and likewise it is easy to purchase a bike.

Guidance for the year

The company reiterated their full year guidance. They expect $100 million of revenue in 2018 and “in excess” of 10,000 units for the full year.

They changed the way they are getting to the $100 million from what they said on the previous call. Management had previously guided to $100 million but on 8,100 units sold. Their mix has changed. Rather than expecting sales would be dominated by Harley’s they now expect a better balance between Harley’s and non-Harleys. Harley’s are higher price, lower margin units.

This is a really new business and I don’t feel like management (led by CEO Marshall Chesrown and CFO Steve Berrard) know exactly how all the levers will play out. They’ve been surprised by the number of non-Harley’s, surprised by the number of dealers buying, and surprised by the strength and margins they are getting from the auction channel.

Nevertheless I’m pretty confident that Chesrown will navigate his way through this. The guy has a impressive background.

Management

Chesrown started off selling cars first in San Diego and then in Colorado, where he was managing 17 dealerships by the time he was 25. He started his own dealership chain soon after which was eventually bought out by AutoNation for $50 million. He has been called the “best used car salesman in the country”. There is a great biography of his early life in this article in the Inlander.

After making a fortune in the auto business Chesrown tried his hand in real estate development and lost it all in the crash of 2008. But not to be deterred he went back to his roots and founded Vroom in 2013.

Chesrown was COO and a director of Vroom until 2016, when he left to start RumbleOn. Though Vroom has hit on harder times this year, it was valued at over $600 million last year.

There are some similarities between the model used by Vroom and RumbleOn but there are also differences. I get the feeling Chesrown learned there and the learnings are now being applied. There have also been a number of executives that have left Vroom for RumbleOn.

Steven Berrard, the CFO, also has a pretty crazy history. He was the CEO of Blockbuster in the 90s, left there to work with (his friend?) Wayne Huizenga as COO of AutoNation, and from there took over Jamba Juice and eventually became CEO. He also led Swisher, which eventually ran into accounting problems but that was all after he left.

It’s a little nuts to me that these guys are leading an $80 million market cap company.

The management team and directors own a lot of shares. Together its about 75% of the Class A and Class B shares. Chesrown and Berrard own 36.5% between the two of them, and together the two own all the (1 million) Class A shares, which have 10:1 voting rights and effectively give them full control over the direction of the company.

Profitability

Buying and selling motorbikes online is new but buying and selling vehicles is not so much. In addition to publicly traded Carvana and Vroom, there have been Beepi, Shift, Fair, Auto1, Carspring and Hellocar and a bunch of others.

These companies haven’t all been successful. From what I can see Beepi, Carspring, and Hellocar all ran out of money. Shift and Fair seems to be doing ok, though Shift has had some bumps in the road by the looks of it. Auto1 is a German company that seems to be doing well.

I think the basic problem with theses businesses is what you see in Carvana’s financials. It takes a long time to get cash flow positive. Carvana has already been around for 5-6 years and yet when I look at the estimates it doesn’t look like they are expected to generate positive EBITDA until 2020.

So these companies need a source of funds to keep themselves going. When those funds dry up, like they did for Beepi, the business goes away.

RumbleOn has similarities and differences here. This is low margin and always going to be. In the first quarter RumbleOn had gross sales profit, which is defined as the difference between the price RumbleOn bought the bike and the price they sold it at, was $1,132 per bike, or 12.3%. Gross profit, which includes costs associated with appraisal, inspection and reconditioning, was $788 per bike, or 8.6%.

The average margin on a Harley was 7.5% while for non-Harley Davidson’s it was 13.1%. Non-Harley’s seem to have a higher gross margin than Harleys, which has to do with their lower price point.

So it’s a low margin business and always will be. So RumbleOn needs to be tight on expenses and focused on volume.

That’s why I think the thing I like best about what I hear from Chesrown and the RumbleOn management team is their focus on getting to profitability and inventory turns.

They want to get RumbleOn to cash flow positive quickly.

Breakeven

Berrard laid out where they would be in terms of costs by the fourth quarter. They also said the goal is to be cash flow positive by the fourth quarter. Guidance for the year is $100 million of revenue, 10,000 bikes sold.

To get to the unit sales guidance they need to sell 4,500 bikes by the fourth quarter, up from 878 in the first quarter. I’m assuming they hit their second quarter guidance of doubling bikes sold in the second quarter.

I took all the guidance information and made a few assumptions around consumer sales (expecting it to rise from 9% in Q1 to 25% in Q4) and their warranty financing (expecting uptake/dollar value to rise from 35% in Q1 to 53% in Q4), and I came up with a break-even model (thanks to @teamonfeugo for helping me work the kinks out of the model).

So I don’t know if this model with be accurate. The business is new, there’s some guessing on my part and I’m just going on what we know from the calls. But what is clear is that the growth is significant and if they can get there by Q4, then 2019 should be the year of cash generation.

It’s also worth noting that margins so far are primarily driver by the vehicle margin. Companies like Carvana are generating about half their margin from financing and warranty sales.

Comps

RumbleOn has 12.9 million shares outstanding. So at $6.25, which is roughly the average price I bought the stock at (I know its ran up the last couple days but I don’t want to redo all of this again), the market cap is about $80 million.

Compare that to Carvana, which has a market capitalization of over $6 billion. Carvana is of course much bigger. But on a per unit basis, RumbleOn looks very reasonable.

Carvana has higher gross margins per unit than RumbleOn but that is because of financing, service contracts and GAP waivers. As sales to consumers grow RumbleOn can expand these other offerings.

On just a pure selling price minus purchase price basis, once scaled RumbleOn has pretty comparable margins to Carvana. It also took them a lot less time to get there (Carvana vehicle unit margins were only about $600 as recently as last year).

It’s hard to look for comparisons from the other online car companies. Vroom, Shift and Fair.com are all private and I can’t find much information on valuation or how many cars they sell. The only somewhat interesting observation I can make is that in terms of unit inventory (this of course being cars for these three companies versus bikes for RumbleOn), they do not appear to be significantly larger. Vroom has about 2,500 cars on their site, Fair has a little over 7,000 and Shift only has about 800. RumbleOn was a little over 1,000 at last glance.

Multiples

Here’s a table of what RumbleOn’s market capitalization looks like at different revenue multiples and $100 million of sales. The 3.4 multiple is based on Carvana’s forward 2018 revenue multiple.

I realize the numbers are high, but it is what it is. I’m using the company’s guidance and Carvana’s multiple. Consider that RumbleOn is growing faster than Carvana at this point.

What sort of multiple does RumbleOn deserve? I’m sure you can make an argument that because the margins are low, the multiple should be low. That’s one perspective. But they are also growing like a weed. And then there is Carvana. If Carvana gets almost a 4x multiple, I don’t see why RumbleOn shouldn’t get at least something above 1, probably more. That multiple should grow as they become more established.

I realize that the used car market is way bigger and so maybe there is a premium for that. But used bike sales aren’t exactly small themselves, especially compared to RumbleOn’s size. According to their S-1 there were 800,000 motorbikes sold in 2016 and 50% of those are done on a peer to peer basis. Then there is the eventual expansion into other sports vehicles. RumbleOn also doesn’t have the 5-10 online and gazillion bricks and mortar competitors fighting with them for share.

What to look for

First, I want to see the website inventory continue to expand. Offers should continue to grow and acceptance will hopefully increase. At the same time their days sales are equally important. That number was 42 in the first quarter versus 38 in the fourth quarter. Carvana days to sale were 70 in the first quarter, down from 93 year over year. RumbleOn has focused on turns and needs to continue to do so.

Second, I want to see consumers comprise a greater percentage of sales, and (ideally) I want dealer sales to take place more and more through the website. But most of all I just want to see sales grow.

Third, I don’t want to see their costs blow up. Costs are going to increase as the business scales but they should also come down to their targets in terms of percentage of revenue.

Fourth, at some point I expect they will expand into other sport vehicles. They’ve mentioned expansion into ATV’s, UTVs, snow machines and watercrafts as other targeted areas.

Conclusion

Online used vehicle selling is a tough space to be in. Carvana has a great chart this year but there was a lot of skepticism (and a high short interest) when it went public.

A lot of other players have ran out of cash. Beepi, Carspring, Hellocar and now Vroom have all struggled.

But all these guys are all selling cars. I think RumbleOn has some advantages selling bikes.

They are much easier to transport.

They are a niche market compared to used car sales and thus more difficult to sell yourself via Craigslist or Kijiji.

They don’t have the same level of competition online. And their traditional dealer competition is arguably less savvy than the used car dealer incumbents (remember that a lot of used car dealers take bikes on trade but don’t want to sell them, so they are actually a source of inventory to RumbleOn).

They are also offering a quick cash, no haggle, simple model for buying and selling bikes in a business that has traditionally relied on squeezing extra margin by making the process as difficult and opaque as possible.

The other advantage here is that RumbleOn is 100% online. On the last call they talked about how they can scale without adding to headcount outside of marketing and technology. They basically operate out of a single building. They aren’t even touching the inventory themselves.

The other advantage RumbleOn has over most (not all) of the online car players is that they’ve involved the dealers. Like I said earlier they are agnostic on the distribution channel. They will sell to consumer, dealer and auction.

This allows them to ramp sales (albeit it at a lower margin) much faster than if they had to rely exclusively on consumer marketing of the app and website.

Finally, I think these guys have the right idea by focusing on inventory turns. They don’t care who they are selling to, and they aren’t trying to squeeze every last bit of margin out of the sale. They just want to get that inventory in and ship it out as quickly as possible.

When they get into power boats, snow machines and ATV’s I think most of these advantages are amplified.

If I’m thinking about this right, growth is gated by how quickly they can acquire inventory. Given the rate at which cash offers and acceptance are increasing, I think that is well under control.

So it looks pretty interesting. Nevertheless its a tough business because gross margins are guaranteed to be low. Its all about driving volume, keeping costs down and where possible upselling through warranties and financing.

So far they doing all of this quite well.

As you know I usually take a small position (usually 2% or a little higher) in a stock and then if it works I start adding as it rises. With RumbleOn, I’m excited enough about the idea to make that higher right from the start. I think if this works it will have some legs. So we’ll see.

So I can’t take credit for this idea. I also don’t have much to say that hasn’t been said already. But I added the stock to my portfolio a couple weeks ago so I need to talk about why.

Smith-Micro is a Mark Gomes stock pick. In fact if you go to his blog you will find so many posts on Smith-Micro that reading them all would keep you busy for a few days.

I’m not going to repeat all the information he provides. I’m just going to stick to the story as I see it, the reasons that I took a position and what makes me both optimistic and cautious about how it plays out (this is just a typical 2% position for me so I’m not betting the farm).

Yesterdays Smith Micro

Smith-Micro has been a bad stock for a number of years. But it used to be worth a lot. This was a $400 million market cap company stock back in 2010. Revenue in 2010 was $130 million.

At the time revenue relied on a suite of connection management products called Quicklink. This suite of products maintained and managed your wireless connection as you moved around with your USB or embedded wireless modem (remember those!). They also had a visual voicemail product that transferred voicemail to text and provided other voicemail management features (in fact they still do have this product).

From what I can tell it was Quicklink that was driving revenue. They had 6 of the 10 big North American carriers onboard and 10%+ revenue contributions from AT&T, Verizon and Sprint. It was a cash cow.

Now I haven’t figured out all the details of what happened next, but the short story seems to be that the smart phone happened. Smart phones had embedded hot spots or mobile hotspot pucks for accessing mobile broadband services. No more dongles, no more laptops looking to keep their connectivity. And the connection management product was no more.

That was pretty much it for Smith Micro. The company never recovered. 2011 revenue was $57 million. 2012 was $43 million. By 2014 it was down to $37 million.

Today’s Smith Micro

The struggles have continued up until today. Over the past few years the company has had a difficult time creating positive EBITDA and revenue growth has been in reverse. Revenues bottomed out at $22 million last year. It’s gotten bad enough that the company included going concern language in the 10-K.

The company currently has a suite of 4 applications.

CommSuite is their visual voicemail product. It is still used after all these years and generates about 60% of revenue. QuickLink IoT seems to be a grandchild of the original Quicklink products but with the focus on managing IoT devices. Netwise seems like another Quicklink spin-off, managing traffic movement for carriers by transitioning devices from expensive spectrum to cheaper wifi where they can while insuring that an acceptable connection is maintained.

So those are the other products. But there is only one that is really worth talking too much about and that’s SafePath.

SafePath is a device locator and parental control app. With the app installed on all devices in a household a parent can keep track of their kids or the elderly (or spouse for that matter) as well as control and limit what apps and access each device has.

Smith Micro gave a rundown of the SafePath functionality in their latest presentation, comparing it these app store based competitors.

Essentially what these apps let you do is a combination of:

Keeping tabs where all the other devices in your network are including geofencing alerts if the location is unexpected (ie. children not in school)

Panic button if a family member is in trouble

Content constraints on what apps can be downloaded onto each device, what websites can be visited

Time constraints and time limits on when apps and web content can be accessed

A history of device usage, location

I think it’s a pretty useful product. I actually didn’t know that so much functionality was available for parents to control what their kids have access to (my kids aren’t at that age yet but I could see a product like this being a purchase for me one day).

SafePath isn’t a unique offering. There are several apps on the market that offer a combination of the features. Each carrier seems to offer some sort of flavor. And there are freeium products available at the app stores, such as Life360 and Qustodio which are the comps used in the table above.

Both the Life360 and Qustudio apps are not associated with any carriers. You get them via the app store and you get some reduced version of the product for free (can only track a couple member of the family, don’t have all the controls, etc). You upgrade to the premium pay version if you want all the features.

For the premium version the pricing on the Qustudio app is between $4.50 to $11 per month depending on the family size. I believe the Life360 app costs $5 per month but I can’t really find recent information on that, and I would need to sign up to get pricing via the app itself which I can’t do here in Canada.

Before I talk about the SafePath pricing, I want to mention that maybe the most important differentiator for SafePath is the white label. Rather than providing a product into the app stores, Smith Micro licenses the app to carriers. They put their own labeling on it and offer it to their clients.

That’s where Sprint comes in.

Why SafePath?

Last fall Smith Micro added Sprint as a SafePath customer. Sprint obviously is a huge win, with 55 million wireless customers.

Sprint has named their version of the app Safe & Found. The product was launched near the end of 2017 but didn’t really accelerate until the last couple of months.

Prior to Safe & Found Sprint offered a product called Family Locator that provided location detection for families. They had a separate app for parental controls called Family Wall. These products didn’t work at all on iOS.

Combining the functionality into a single app that’s available on all operating systems is likely part of a bigger strategy. At the LD Micro conference William Smith, the CEO of Smith Micro said this:

[Safe Path is] an enabling platform for a carrier that is looking for a strategy to grow their consumer IoT devices… [such as] wearables, pet trackers, a module that goes in your car and lets you track your teens driving, a panic button that you give to your parents…

Putting together a single product geared at families is about attracting families to the carrier. Families are low churn and high dollar value customers.

Sprint is selling the Safe & Found app for $6.99 per month, so in-line with the other apps that are available. Smith Micro has a revenue sharing agreement, taking a cut on each customer. Apparently, Smith gets about $3/customer/month from Sprint (though I haven’t been able to verify that number).

The Sprint Bump

Ok so now let’s throw out some numbers.

Smith Micro has about 24.5 million shares outstanding. At $2.50 that gives it a market capitalization of $61 million. There is about $10 million of cash on the balance sheet (maybe a bit more but they are still burning cash so call it $10mm) and $1.5 million of debt.

TTM revenues were about $23 million and gross margins are 75-80%.

Now let’s look at what Sprint does to those numbers.

On the fourth quarter conference call Smith said:

While the conversion of Sprint’s existing customer base is still underway, it will equal approximately $3.5 million in additional quarterly revenue for the company once it’s completed.

That’s including breakage. So this is a $6 million revenue per quarter company that is guiding that it can add $3.5 million a quarter on a Sprint ramp? Obviously, that’s the opportunity here.

The company said that margins on SafePath will be around 80% and that almost all that margin should fall to EBITDA.

Not surprisingly, if you model this out the company becomes much more attractive.

The above assumes 6% operating cost inflation (gets you to $6.2 million per quarter).

An analyst on the fourth quarter call said Sprint’s installed base was about 300,000 customers, so the above would assume a ramp of those customers (with breakage) to Safe & Found (I would really like to have this number verified though, I can’t find evidence of how many Sprint’s Family Locator subscribers there are anywhere else). Its worth noting that if the 300,000 subs is accurate it is is less than 1% of Sprints installed base. So there’s clearly lots of blue sky if all goes well. On the fourth quarter call Smith said that:

I think it is the goal of not only Smith Micro but also of Sprint to see millions of subs using the SafePath product and that’s a goal that, I think, would be echoing in the executive aisles of the Sprint campus as well.

So we’ll see. The numbers can get quite big when you are dealing with 80% margins and a large installed base.

Can Reality match the Model?

That’s the big question. Are these numbers achievable?

Look, I take small positions in a lot of little companies that give a good story. I tend to take management at face value.

This is a bit unconventional. I get called out for it by more skeptical investors. When these investors are right, which is more often then not, then they get to gloat and I get to look like a naïve fool for trusting management.

But bragging rights aren’t everything. There is a method to my madness and that method is that when I am right, I sometimes get a multi-bagger out of it. The big wins drive the performance of the portfolio and while on a “naïve-fool-basis” I come out looking poorly, I also come out profitably.

Nevertheless, I always try to keep it at the forefront of my mind that there is a pretty good chance that this isn’t going to end well.

With Smith Micro I’m taking management at face value. If they say they can do $3.5 million a quarter from Sprint, then okay, I’m buying the stock on the basis that they do $3.5 million a quarter from Sprint. They say the goal is for millions of subs then I say, okay, lets see that happen.

But I also recognize that might not happen.

My Concerns

Honestly my biggest hang-up with the stock right now is the reviews. The reviews on Google Play could be better.

I recognize you have to take these reviews with a grain of salt. First, they make up a very tiny percentage of the total downloads so far. Gomes put together a very helpful table of his estimated downloads and the reviews that have been added. Reviews are much less than 1% of downloads.

Second, its not clear that the reviews are all legitimate. I haven’t done this, but some others have dug into the reviews and questioned that they are often coming from locations that aren’t even in the United States.

Third, apart from a few legitimate concerns like battery drain (which other reviewers actually contradict), most of the reviews seem to be more about complaining that the Family Locator app they were used to is gone. Fourth, the trajectory of the reviews has been getting better.

Nevertheless the reviews are a datapoint and right now a somewhat negative one.

My second hang-up with the stock is that, at least from what I can tell, Sprint hasn’t completely shelved their legacy Family Locator app. On the first quarter call Smith said this:

The legacy product was originally due to sunset in the first quarter of 2018, but has subsequently been delayed for several months. This change was based solely on Sprint operations and was not a result of the SafePath application or change of our contract status.

Why has Sprint delayed the sunset? I have no idea. It could be (probably is) a completely benign reason. But again, it’s a bump in the road to weigh against the $3.5 million a quarter that I am taking at face value.

My third concern is that management hasn’t been on target with their projections. Originally they said the ramp on the Sprint installed base would be complete by the first quarter of 2018. That turned out to be way off. They were also positive on a Latin America carrier win that doesn’t appear to have panned out.

Finally, concern number 4 is that we are dealing with a service provider. These guys are A. Slow to adopt, and B. not at all loyal. We’ve already seen point A prove itself out as the ramp has lagged. Point B is something I’ve already experienced with Radisys, which was dumped unceremoniously by Verizon. Smith Micro has had this experience multiple times in its history, most recently by Sprint themselves when they dumped their NetWise product after what Smith Micro called a promising launch.

These are all reasons this is a 2% position for me.

On the other hand, Sprint does seem to be moving ahead. There was a big promotion in May including a joint deal for AAA members (talked about here), reps have been visiting stores and getting the sales staff up to speed, and stores are promoting the app to varying degrees.

One other potential positive is that Sprint might not be the only Tier 1 win. The CFO, Tim Huffmyer, presented at the Microcap conference in April. He mentioned a second win with a Tier 1 European carrier.

Huffmyer said that they had already been selected as the family safety application for this carrier but that the contract process was still ongoing. If they get the contract finalized it would be rolled out to Europe, Asia and the Middle East where this carrier operates. He didn’t give any more details on size but presumably it would not be a small rollout.

I know from painful experience how slow Tier 1 wins can be. But quite often they get around to it. It’s a good sign that they are moving down that road with others.

A Typical Stock for me

This is a Mark Gomes pick and I am stealing it. But I am stealing it because it fits right in my wheel house.

There is no question the stock could be a dud. The Sprint ramp might stagnate, Sprint might walk away and go back to the incumbent or to some other option, and then there is the merger with T-Mobile that throws yet another wrinkle into the equation. Who knows what’s in store?

The one thing I do know is that if the launch is successful and Smith hits their targets, the numbers are big enough to justify a higher stock price. Viable growing businesses with 80% gross margins and a recurring revenue model don’t trade at 1-2 times revenue. Simple as that.

So this is a classic stock for my investing style. An uncertain opportunity that has some positives, some negatives, no sure thing, but an upside that is more than large enough to make it worth throwing your hat in the ring.

How often do these sorts of opportunities pan out? Definitely somewhere south of half the time. If it doesn’t then I get to look like a naïve fool for trusting management. But if it does I get a big winner. It’s these sorts of moonshots where the 5-baggers come from. And that’s what drives the out-performance. Crossing my fingers that Smith-Micro will be next.

I don’t expect this position to be a long-term hold for me. There are a number of things not to like about the stock. Nevertheless the beaten up share price over the last couple of months presents a disconnect to the underlying assets that is historically large and I think has a reasonable chance of being corrected over the coming weeks and months.

NL Industries has 49 million shares outstanding. At $8 that gives it a market capitalization of $400 million. They have about $100 million of cash on the balance sheet. They have no debt, but do have a long-term liability for environmental remediation that is $115 million. These costs are associated with previously operated lead smelters and mining operations. They also have legal proceedings ongoing, which I will get to shortly.

NL Industries is a holding company that has ownership in two businesses. The first is Kronos. Kronos is a large, titanium dioxide pigment producer. NL Industries owns 30% of Kronos. Kronos used to be a wholly owned subsidiary but they have slowly divested that into the public market.

Titanium dioxide is used to create a white pigmentation in paints, plastics, and other coatings. Those that follow this blog might remember that I have previously held a position in another titanium dioxide producer, Tronox, and from that experience I learned that this is a tough business. Kronos has a 9% market share in the Titanium dioxide market worldwide.

The titanium dioxide market is quite cyclical. Kronos stock traded to as low as $3 at the trough of the last cycle, but we are now on an upswing as demand has been rising and little new production is on the horizon. The stock has risen from $12 to $18 since the beginning of the year.

The second business that NL Industries owns is CompX. Their ownership in CompX is 87%. CompX is a manufacturing company. They have a segment that manufactures locks and another that manufactures marine components. CompX has been consistently profitable and free cash flow positive for the last 3 years, but has not shown any growth over that time.

In addition NL Industries owns 14.4 million shares of Valhi, which is a related company that also owns a stake in Kronos. These shares are worth a little less than $50 million. The relationship with Valhi is complicated as Valhi in turn has 83% ownership of NL Industries. Valhi is 93% owned by the private company Contran, which is owned by the family of Harold Simmons. There are a number of interesting articles on the late Mr. Simmons and his controversial life (here and here for example).

While the ownership structure likely raises some questions about the long-term direction of the business, my thesis here is very short-term, so I am not going to dwell on it. By the time any strategic concerns are realized I should be long gone from the stock.

Getting back to the assets, neither Kronos or CompX are particularly bad businesses, but neither is either a particularly good business. Kronos is cyclical and requires large capital expenditures. CompX is in a low growth end market. I probably wouldn’t invest directly in either company.

What makes NL Industries interesting is that their stake in these businesses far exceeds the market capitalization of the stock. CompX has a market capitalization of $170 million. NL Industries has a 88% interest in them, so that is worth $150 million. Kronos has a market capitalization of $2.2 billion. The 30% ownership that NL Industries has is worth $660 million.

Thus, NL Industries has a market capitalization of about half of its underlying ownership in Kronos and CompX.

The story would be that simple, but it isn’t. There is one remaining caveat. The company has went through a number of lawsuits with respect to its production of lead based paints back in the 1980s. Almost all of these suits have been ruled in their favor. But there is one exception and that is the lawsuit brought about by the county of Santa Clara. Their suit, like all the others, alleges that NL Industries and other lead paint producers are responsible for compensation and abatement costs because they sold lead paint back before it was realized how dangerous it was. The suit is against NL Industries, Sherwin Williams and ConAgra. You can read about the details in their 10-K.

This suit has gone back and forth. The original verdict dismissed the claims, but an appeal overruled and ordered NL Industries and its counterparts to pay damages ($1.1 billion). But this ruling was not final and there is now a second appeal in process. This SeekingAlpha article outlined a few different legal opinions that expressed surprise at the second ruling and that expect it will be overturned on the next appeal. What is surprising is that at the time the lead paint was being sold, there were minimal concerns about its long-term environmental effects. It is unusual to hold a company accountable in such circumstances.

Its important to note that the lawsuit has been ongoing for some time and there hasn’t been any developments since January 2014 when the appeal overturned the original verdict. Also worth noting is that the stock did not react much at the time of the January 2014 appeal result. There is also nothing in the immediate future that will change the state of the trial. The timeline for the second appeal trial has yet to be set. My point here is that insofar that this risk should be reflected in a discount of NL Industries to its underlying assets, that discount shouldn’t be any different today than it was 3 years ago.

Keeping that in mind, when I look back at the stock price of NL Industries, Kronos, and CompX over that time, I notice that the current relative price is close to the bottom of the relative range of NL Industries. To throw out a few data points:

NL Industries trades in a range of 40-75% of the value of its underlying ownership in Kronos and CompX. Other than when the titanium dioxide industry was in the depths of a recession (in late 2015, early 2016) the stock tended to trade closer to the higher end of the range. Right now it trades at under 50%. Other times when the delta became that large, it eventually rebounded back to the 75% range. If I’m right, the stock should move back to $11 or $12, which would be a nice gain.

The risk of course is that A. the rebound does not occur this time or B. that Kronos, which is a very volatile stock, falls significantly from its current near-52-week highs. I am wary of both possibilities, and am not making this a large position for that reason. It’s a 3% position in my value portfolio. I am also not planning on holding this stock for too long – hopefully it rebounds back into the usual range and I sell for a nice profit. If it doesn’t rebound relatively quickly, I don’t plan to overstay my welcome.

I was wrong with the header bidding angle, but have been right about the company (so far).

Header bidding is an advertising technology designed to source the best pricing for ad space on webpages. This isn’t the ad space that Sito Mobile operates in. Sito operates in the mobile app ad space. They have an interesting offering. Here is how Sito described what they do at the Cowen Conference last year (I’ve paraphrased a little for brevity).

What you see here is a day in the life of a mobile user. Its important to note that when we interact with our phone and click on an app, we are raising our hand and saying serve me an ad. Our platform sees every one of those bid requests. If you look at this user (see timeline above), this person wakes up in the morning and clicks on their weather app. Every time that they click on an app we gather information. We gather a minimum of 3 data points and depending on the app and agreements, up to 30 datapoints. At minimum we gather the geo-location, time stamp, and the device ID. All the data is anonymized. That’s the foundation of how we create something called player cards.

The next time we see this device ID at a geo-location its 7:15AM. It’s an elementary school. The next time we see the device ID its at a geo-location that is a Planet Fitness. So you now see a pattern. Next we see it at a grocery store. Last we see it at 10:04AM is at a location we’ve seen the device 382 times in the last 30 days, so we can infer that this is likely the home address. Then we can get additional data from the Wifi about number of devices and carrier for that home address. We can then layer on third party data from Axiom and DLX and the like to layer on things like household income, demographics around that area, and we start to build a profile. We never know 100% but in this case we have a high degree of probability that this is a Mom, age 35-44, Caucasian, lives in zip code with average household income of $220,000, college educated, likely own their own home, average length of residence is 7 years, married and has average of 2 children ages 2-9.

That now goes into an audience that we create. We then layer in her interests and that resulting player card can then be used to target advertisers who want to speak to this consumer.

Once a user has been targeted with the ad, Sito can follow-up on the path that the user follows. Via it’s Verified Walk-in product Sito can report back whether the user subsequently entered the premises of the ad vendor, thus verifying whether the targeted ad was a success.

While some would legitimately remark that it’s scary how much can be known about you by carrying your smart phone around, the other way to look at it is that it is that the platform should result in more relevant ads being presented to users. The mobile location history that Sito collects allows it to profile the user, understand their interests and routines, and then target an ad that is appropriate and maybe even useful. And because of the real-time location data, the ad is also relevant to their current location. The verified walk-in allows Sito to report back to the advertiser with accurate metrics about the campaigns success. The value proposition makes sense to me.

The stock price suffered into the new year for two reasons. First, the company badly missed expectations in the fourth quarter. The fourth quarter should be the best one for advertising. Yet media placement revenue was down from $10.4 million in the third quarter to only $8.3 million in the fourth quarter.

This was compounded by news of malfeasance by the CEO and CFO. Apparently they were making unapproved purchases with company credit cards, debit and withdrawals from payroll funds. In total $330 thousand dollars that were misappropriated. In February these executives resigned.

So there was concern that the companies growth trajectory was failing and concern about the void at the executive level. The stock plummeted down into the $2’s.

I got interested after the company released its first quarter results. In fact I think (I can’t remember for sure) I got the idea after reviewing a list of percent gainers the day that they reported.

The first quarter results were better than the fourth quarter. Revenue was down from the fourth quarter (not unexpected given that January is typically a dead month for advertising) but up 34% year over year. More impressive, the company said that it had its best month ever in April, generating over $4 million in revenue, and they guided to a range of $10 million to $13 million in revenue for the second quarter. This would be far above the $8.3 million of media placement revenue for the prior year.

So I like the offering and I like the recent growth trajectory. When I bought the stock at $3 the market capitalization was a little over $60 million, which meant that it was trading at less than 2x forward revenue, quite cheap if the company has indeed regained its growth mojo. Even now, at $4, its still only 2x revenue, which is not an expensive price tag if 30% revenue growth is really in the cards.

So it’s a simple story. Growth business, product/service that makes sense, they even have a wealth of data that they have archived over the past couple of years that they are beginning to monetize as data as a service and that will provide an additional revenue stream. Simple.

Except its not. The complicating factor comes from two activist groups that are looking to replace the board, replace the new CEO and CFO and I think put the company up for sale.

The two groups are the Baksa Group and TAR Holdings. The latter company is owned by Karen Singer, wife of Gary Singer, who had this interesting article written about them a few years ago. I didn’t know anything about either of these groups before investing in Sito. Singer and TAR own over 10% of Sito while the Baksa Group own a little less than 7%.

The groups say that they are not affiliated, though they seem to support each others claims and want essentially the same thing. What they want is the removal of the executive team (the CEO and and CFO) and replacement of 4 of the 5 directors. In this filing (one of many) the Baksa Group describes their position and what they are looking to change.

There are lots of complicating and curious angles here. Just to throw out a bunch of facts: Stephen Baksa was a director of Sito from 2011 to 2014. The Baksa group appears to be supported on the board by one of the Sito Directors Brent Rosenthal (the only director they don’t want to replace). One of the Baksa nominees purportedly has a “working relationship” with the Singers. Some of the Baksa nominees sit on the board or are affiliated with a company called Evolving Systems. Karen Singer owns 21% of Evolving Systems. A couple of Singer’s relatives work with Evolving Systems. And it seems like all of this activism started shortly after a March meeting between Sito management and Thomas Thekkethala, who is the CEO of Evolving Systems and was to become one of Baksa’s board nominees, where they met to “discuss a potential licensing arrangement that would allow the Company to market its products to Evolving Systems’ customers outside the United States”. It was 4 days after that meeting, on April 4th, that Sito adopted a poison pill and the activist ball got rolling.

I don’t really know what to make of the activist angle. Maybe this is all a way for Evolving Systems to take over Sito, maybe there is something else going on. I really have no idea. I’ve read through all the filings and I honestly couldn’t pick out any tidbits that gave me certainty about the outcome. Where we stand now is that the Baksa group has delivered a proxy signed by 58% of common shareholders supporting their proposals to remove the current executive and directors and replace them with the Baksa slate. Sito has responded that they are having a third party do a count and validate the results and will report back next week.

While I am really not sure about the outcome, it seems to me that its at least possible that this ends in some sort of acquisition of the company. Management has their backs against the wall with the recent proxy. The easiest way out of the corner is a takeover, either by Evolving Systems or some other white knight. And if it doesn’t happen, there are always the fundamentals to fall back on, which is the real reason I bought the stock.

The win is for the design of a new, custom 100G switch fabric NIC to be deployed in datacenter racks. The design presents a number of technical challenges and they are still working through those challenges. So far Silicom has received an initial $25 million purchase order and a follow-on $8 million order from the customer. The PO’s are being written even though the card is still in the beta phase and thus still under development. The PO’s are to insure that Silicom has components on hand and can ramp production quickly to the $30 million plus run rate once a final design is approved.

Interestingly, Shaike Orbach, Silicom’s CEO, said that they were engaged with 10-15 other cloud players for similar designs. He tempered those remarks by saying that the sales cycle was long (can take as much as two years), that some of the engagements would be for smaller wins (but some could be bigger) and that the architecture of all cloud vendors do not line up as well with Silicom’s technology as this vendor did.

At any rate though, there is a large pipeline of potential deals. As an aside, if anyone knows who the existing win is with, please email or direct message me.

SD-WAN

There were also comments around SD-WAN. They have a similar number of SD-WAN prospects that they are talking to (around 10). These include traditional telecom vendors that have SD-WAN solutions, start-ups, and even service providers. Talking directly to service providers is a new development as Silicom has traditionally worked through OEM vendor channels.

There was a bit of color around the potential of the SD-WAN opportunity. Alex Henderson from Needham asked the following question:

If it’s the entire white label box at the edge, I would think that A, that would be a little bit lower margin but B, a lot of revenue associated with that because we’re talking about 1000s of branches and individual deployments here, that seems like a very big ramp when that starts to kick in. Am I thinking about that right? I mean it seems like a very large number?

Orbach’s response was to agree that potential quantities were “very big” and that they had some competitive advantage in that they could provide features not available from others. I’m still quite excited about the SD-WAN opportunity.

FPGA Opportunity

One comment that came up a few times on the call was the growing importance of their FPGA solutions. Orbach said that while the switch fabric win is not an FPGA solution, Silicom’s FPGA capabilities were instrumental in getting the win as the customer expects future generations of the product to require FPGA’s.

At the end of the call Orbach gave more color around the importance of FPGA solutions (my underline):

So first of all I would like to tell you that we think that FPGA technology and solutions around FPGA are going to be extremely, extremely important. We’re investing in that. You understand it may take some time but we believe that it will be extremely important. Just like you have said, I mean one of the reasons I mean there are two I would say trends, not trends, but two events and — well even event is not the right word but two things which are happening together which I believe are important to understand, maybe even three. So one is again the cloud, I mean the cloud, I think that cloud vendors do understand today and that’s by the way why we have been able to success even with that customer that in order for their cloud to be effective, in order to cut down their expenses they need to have several ways or to do offloading within the cloud. Our FPGAs seem to be recognized now almost by everyone as the right technology for the purpose of doing this kind of offloading. I think that although — when I’m saying cloud by the way I mean the whole package, I mean it’s cloud and NFV, SD-WAN virtualization, all that together. So when build systems using these technologies you would need to do offload, the right technology to do offload is FPGA.

Orbach also hinted at collaboration with Intel (and their Altera FPGA designs) and referred to a MOU around FPGA development that he said was important.

I did a little bit more research into FPGA development and this looks like an area that is beginning to hit its stride with more and more use cases. FPGA designs offer more flexibility, less up front cost and are preferable to vendors that either don’t want to commit a large spend to a custom ASIC design or do not have funds to commit to such a closed end design. It sounds like the performance gap with ASICs, which has largely been what has limited their use, has closed considerably over the last few years.

In particular I found one white-paper by Altera/Intel that was particularly insightful. The paper describes 3 evolving use cases for FPGA’s that all seem very closely aligned with Silicom’s strengths. They are:

Datacenters

400G cards

Wireless Remote Radio Units

The paper basically suggests that the requirements of the next-gen designs will fit much better with FPGA solutions than ASIC solutions.

While Orbach and the above paper suggest that big FPGA wins are still some time in the future, it really starts to clarify the runway of opportunities for Silicom for me. I think this could be a multi-year run for the stock as the company seems very well positioned for trends to white-box hardware, offload functionality to secondary NIC cards, and utilize more FPGA based solutions. I didn’t add to my position on the results, but if there was enough of a correction I certainly would.

I’ve had a small position in CUI Global since last summer. I first wrote about it here. The thesis has been that their gas measurement technology (called GasPTi) is quite a bit better solution than traditional measurement techniques, that slower than anticipated adoption from utilities has punished the stock but that adoption of the technology is on the verge of inflection. But even at the time I wrote rather presciently:

Given this trajectory, it’s most likely that even if the story works out it will A. be delayed longer than anyone would have expected and B. have a number of false-starts and hiccups before finally showing consistent growth.

Since that time the corner of that inflection continues to be turned, just not very quickly. Not surprisingly the stock hasn’t done much.

Until the recent quarter the company gave me little reason to add. In fact, prior to the quarterly release I reduced my position a little on anticipation that the market would react negatively to what seemed like a near certainty to me: that their major customer for the GasPT product, Snam Rete, would continue to be delayed in installing gasPT units because of a regulatory hang-up, making the fourth quarter and likely first quarter guidance sub-optimal. Even though this should have been widely anticipated, small caps are forever inefficient and so I thought it probably wouldn’t be.

That is exactly what happened. The company reported a crummy fourth quarter revenue number ($19 million versus $23 million in the third quarter), and much reduced sales from their energy segment ($5.6 million versus $7.1 million in the third quarter). The first quarter guidance was no better. The stock has sold off since.

Yet I feel tentatively optimistic about the company’s prospects. I added to my position, but just a little. Here is my reasoning.

First, though Snam Rete continues to be held up by a regulatory hurdle, I am inclined to believe management when they say that this will be resolved. They commented that Sanm Rete has a team working with the regulator, that they have worked through similar issues before, and that Sanm Rete is close enough to resolution to have originally thought it would be resolved by year end.

As long as you believe the management story, it doesn’t seem like this is anything insurmountable. And a single news release noting that the hurdle has been cleared will likely lead to a resumption of Snam Rete’s run rate of 100 GasPT unit installations a month and a significant pop in the stock.

(100 units at $15,000 per unit is $4.5 million per quarter, which would boost their energy segment to almost double the fourth quarter level)

While the poor results and stand still on Snam Rete have taken the focus, the news that has been ignored is that CUI Global did get another big player on-board. I was way off in my original write-up, thinking such an event would be a huge catalyst for the stock. I wrote:

I don’t think you can sit on the sidelines and wait and see how it plays out. Because the next contract, if it happens, will likely be the big move when it happens, and the stock will gap before you can react.

Well they announced that next big player, ENGIE, a large French grid operator, but obviously the stock did not respond as I had anticipated back then. To be fair they don’t have a signed PO in hand, only an agreement for collaboration and a lot of positive color around the deal on the conference call. The market probably wants more.

In addition to France, ENGIE also has ties to PetroChina and owns pipelines and LNG in China, a market where there have been discussions about taking the GasPT product into. So this are potentially two markets that the company can penetrate. The CEO, Bill Clough, didn’t put a lot of numbers to ENGIE on the call, but in the past has said that the opportunity in France is around 2,500 GasPT units (these would be higher pressure units requiring the VE probe for analysis and that therefore would have a higher ASP then the units they sell to Snam Rete in Italy), and he did on the call refer to negotiations of a 1,000 unit project that are ongoing.

One other development mentioned both in the release and on the call was a change in regulation by the UK gas regulator, OFGEM, which will make GasPT units acceptable for smaller installations. Clough said that “once approved our European and UK customers will be able to replace gas chromatographs with our GasPT simply because the economics favor our solution”. I’m not sure how big this opportunity will be, but it is expected to materialize into POs shortly. They also have the previously announced $40 million engagement with National Grid, a UK utility.

Finally, in the electro-mechanical business they continue to talk enthusiastically about their ICE block solution, which is a software/hardware solution for data centers that is intended to reduce power consumption. They said that this year they have ICE block units being tested by “several industry-leading data center operators”, mentioning on the conference call a Fortune 100 DC operator, Fortune 500 DC operator, top tier data center hardware provider (this was all previously announced in this February press release). They also added fourth company in one of largest ecommerce platforms in the world

I’m not as sure about the ICE block opportunity as the GasPT one. They are a partnership with a company called VPS, where they are essentially the hardware provider for the VPS software. VPS describes the ICE Block here, and it doesn’t sound like the hardware is a very important part of it, so what exactly the upside is isn’t clear to me.

Nevertheless even without ICE block, the opportunities with GasPT are enough to keep me interested for now.

While none of this has translated into a positive revenue number or a guidance breakout yet, it all feels very directionally positive to me, and seems more and more like the hockey stick of the inflection is just a matter of time.